Every trader has profitability as a common objective. Without making profit we cannot stay in the game. How do we determine which instruments to trade and how much profit could we take within a traded instrument are questions every trader should ask themselves before a trade session begins.
The Standard Deviation is one particular concept/tool every trader MUST master in order to be able to answer the above questions without much speculation.
Expecting to take 35 points/pips from the next candle when the past 10 candles have had a standard deviation of 8 points/pips is like expecting to get 5 eggs from a chicken tomorrow that has been laying 1 egg a day for the past 2 week!
So, with that being said, let’s dive deeper into it!
What is the Standard Deviation?
The Standard Deviation, applied to trading, is a tool that measures the distance, in points, between the closing of a price and the average of such price.
It is pointless to go into details on how to calculate it as it is readily available on all trading platforms. It can be applied to any average (Simple, Exponential, Weighted, etc) and to any period of your choice.
If we zoom in on the image above illustrated in the following two images we can see every major move in Price, regardless of direction, was followed by an increase of the Standard Deviation since Price moved farther away from the average.
We can also notice that not only every move in Price came after a period when the Standard Deviation was low but more importantly Price seems to be ranging sideways while the Standard Deviation was low.
In Summary, the Standard Deviation can help us determine:
- When prices are ranging represented by low or compressed Standard Deviation values
- When prices are trending represented by an increase in the Standard Deviation values
- When a trending move is loosing momentum and therefore returning to a consolidation/range represented by a decline in the Standard Deviation values.
One issue traders have with using the Standard Deviation tool is that the values will always be different depending on which trading instrument it is applied to. At any point in time, EURUSD will have a different Standard Deviation value than USDJPY or XAUUSD
Why is this an issue you may ask?
Well unlike with the RSI indicator for example which with a value lower than 20, whether on EURUSD or USDJPY, you could say prices are oversold on both charts, there is no fix number we can use for all instruments with the Standard Deviation. Each trading instrument will have its own unique values.
Not only that but since the Standard Deviation moves along with movements of price in relation to the mean (average), using a multiplier of the standard deviation as a stop loss or target value when placing a trade will not be very effective as it can easily double, triple or even quadruple within minutes of entering a trade, therefore taking you out of the trade too early. Let’s look at the example below
Let’s pretend we decided to use a 2x multiplier of the Standard Deviation as Stop Loss and a 4x multiplier as target. Sounds good right? At the moment we entered our Short trade the Price was at 1.07753. The STDEV value was 0.000147 so the StopLoss was 1.07782 or 2.94 pips and target was 1.076942 or 5.88 pips.
By the time the fourth candle close, the STDEV value had gone up to 0.000224 already almost doubling from our entry value. Price closes at 1.07700. Target was hit but price continued moving further down an extra 10 pips. Not too painful but other times could be 100 pips that you left on the table.
Worst situation is when price corrects 1 deviation on the third candle, kicking you out of the trade since the STDEV had double and your 2x multiplier became a 1x multiplier. Your stoploss gets hit and then you see the trade continue in your direction 100 pips.
So, you may ask, is The Standard Deviation then NOT as useful as it seems?
It is, a better approach when it comes to using the STDEV for a stop loss is to setup a TrailingStop instead that adjusts itself automatically with every closing candle. Expanding & contracting along with the values of the STDEV.
On my next post I will explain in details how we can use the statistical theory of Normal Distribution to bring the STDEV indicator values to a fix oscillator like indicator that can be used on any traded instruments, making the STDEV the one and only indicator needed to truly outperform in the marketplace